* FTSEurofirst 300 up 0.3 pct, Euro STOXX 50 up 0.7 pct
* Portugal stocks sag as focus shifts to the country's debt
* Germany's red-hot DAX shows signs of overheating
* Upside risk seen as investors still 'underweight' Europe
By Blaise Robinson
PARIS, March 14 (Reuters) - European stocks ended higher on Wednesday, with benchmarks closing at levels not seen since August, after a drop in Italy's borrowing costs at an auction and a brighter forecast from the U.S. Federal Reserve fuelled the market's brisk week-long rally.
Sharp losses in Portuguese stocks and an underperforming Madrid bourse, however, showed investor wariness about the two countries' ability to deal with their debt piles, which could yet threaten the European market gains made since mid-December.
The FTSEurofirst 300 index of top European shares ended 0.3 percent higher at 1,098.37 points, while the euro zone's blue chip Euro STOXX 50 index added 0.7 percent, to close at 2,574.79 points.
Banks paced the gains, with Natixis up 5.2 percent, Credit Suisse up 5 percent and KBC up 4.6 percent.
"The ECB's two LTROs have had an extremely positive impact on sentiment. The risk of a bank going bankrupt is virtually gone," said Philippe Ithurbide, head of research and strategy at Amundi, which has 659 billion euros ($859 billion) under management.
"Prices continue to recover from capitulation levels seen last year, but euro zone equities are still 20 percent cheaper than U.S. peers. That gives you a pretty good idea of where to invest."
The strategist said fund flow data has shown massive outflows from European equities over the past year, signalling that asset managers are strongly 'underweight' Europe, which limits the downside risk for the region's equities.
"Investors have huge cash positions, and seeing them coming back to even just a 'neutral' asset allocation on Europe would fuel the rally, so the risk is clearly on the upside."
Among the top gainers on Wednesday, Germany's biggest utility E.ON surged 7 percent after reiterating its outlook and saying it made headway with the renegotiation of pricey gas contracts that weighed down earnings in 2011.
PSA Peugeot Citroen gained 4.2 percent following a recent slump as traders pointed to a 'short squeeze' ahead of the company's rights issue.
Overall sentiment was boosted after the Fed upgraded its outlook for the U.S. economy and said most U.S. banks had passed stress tests.
The mood also improved after Italy sold 6 billion euros of bonds at a debt auction on Wednesday, paying the lowest three-year yield since October 2010 thanks to strong demand from investors awash with European Central Bank cash following the central bank's massive liquidity injections.
But Portugal's PSI 20 index dropped 0.7 percent on Wednesday while Spanish stocks gained a small 0.2 percent, falling behind the DAX's 1.2 percent rise on the day.
So far this year, the PSI 20 is up 2.2 percent, Spain's IBEX is down 2 percent, while the FTSEurofirst 300 is up 9.8 percent and the DAX is up 20 percent.
The red-hot German index was showing signs of overheating on Wednesday, with its relative strength index (RSI) moving just a few points shy of 'overbought' territory.
The derivatives market also showed signs of doubts about further gains in equities in the short term, with the put/call ratio on Euro STOXX 50 index options currently at around 1.5, a sign of investor cautiousness overall.
The ratio is used to gauge investor sentiment, and a high volume of puts compared to calls indicates a bearish sentiment.
"A put/call ratio of 1.5 is relatively high, although it's tricky to draw any conclusion," said Vincent Cassot, head of equity derivatives strategy at Societe Generale CIB.
"It might be seen as sending a message of cautiousness overall, with a strong flow of investors seeking protection for their long positions in stocks, but keep in mind that the ratio is being 'polluted' by all sorts of derivatives strategies, such as 'put spreads' which boost the volumes of puts," he said.
"The bottom line is: the ratio is not at extreme levels, so it's not flashing 'buy' or 'sell'."